I straightened out my black trench coat and adjust my dark glasses. I opened the door and stride confidently into a brightly lit room. Covering the walls, hundreds of monitors displayed financial charts. A stately, well dressed, bearded, silver haired gentleman sat upon a high chair, the only interruption to the smooth floor.
"Mister DiFalco, I've been waiting for you..."
"Neo,” I interrupted. "Just call me Neo."
"Very well," the gentleman replied dismissively, "Neo, as you should already know, I am the Architect. I am the mastermind behind selling United States Treasury securities to the citizenry. Your presence here is evidence that my marketing models have failed. Although perfect, they have failed for one reason..."
"Choice," I stated flatly. "The problem is choice."
Retail investors in the United States--John Q. and Jane Public--enjoy a myriad of choices. They can select from stocks, bonds, cash, precious metals, other commodities, derivatives, and real estate; mutual funds consisting of a pool of stocks, and/or bonds, and/or any or all of the above; open end mutual funds or closed end ETFs; domestic or foreign investments. Even subcategories have large lists. Cash can be money market demand deposits, money market mutual funds, foreign currency (insured) demand deposits held domestically, foreign currency demand deposits held overseas, and savings accounts, in addition to the paper stuff. Accounts can be taxable, non-taxable up front, non-taxable back end. Specific investments can be taxable, partially non-taxable, or tax free. Such variety is one benefit of living in a "finance economy."
Choice is the reason why few US individual investors buy their own federal government's bonds (technically, bills, notes, and bonds). The return on investment is too low. Yes, US Treasury securities have the highest safety rating, have no currency risk in the narrow sense, and shelter some people from state income tax on the interest. However, at an interest rate of 4-something percent, there are many other choices that provide higher risk-adjusted returns. In other words, the lower the rate, the more risk an individual can afford. For example, around 2002-03, I put money in a high-yield junk bond mutual fund nominally yielding 9%, because the safe alternative was a Treasury money market mutual fund yielding just under 1%. I reasoned that I could be wrong by 8% per year and still come out ahead. Choice equates to both flexibility and power.
Choice is also partly why the idea that nobody will buy US Treasury bonds if Asians don't is wildly misguided. Most prominently, Asian central banks artificially depress interest rates buy bidding up these investments without regard to value. These price insensitive buyers, aided by a spendthrift US Congress and bubble blowing Federal Reserve, don't want to make a profit. They want to keep their populations employed by using mercantilist policies, the symptom of which is piles of central bank cash with few places to go. At the dictates of their governments, they follow the path of least resistance. Bond prices rise. Yields drop. Low interest rates on US Treasuries are why John Q. and Jane avoid them as if they were a social stigma. That situation won't always be the case, though.
"Okay, Neo," the Architect said, "would you be interested in a 5 year note at 4%?"
"Take a hike, Uncle Sam," I retorted.
"Well then," bargained the smiling gentleman, "would you buy at 5%?"
"Chump change."
"How about 6%?"
"BORing."
"7%?"
"You know, I've really got some errands to run..."
"8% then," said the Architect, getting a little annoyed.
"Sir, over the long run, stocks have returned...[yada yada yada]..."
"9%?" snapped the reclined man, now leaning forward and eyes widening.
"No deal, but keep talking," I replied.
"10%?" the Architect bellowed.
"DEAL!!!"
US investors, particularly baby boomers, won't buy until the interest rate is high enough. I know, I know, I also hear all the blabber about Americans’ savings rates being zero. The eggheads who come up with these statistics also come up with consumer inflation indexes that exclude food and gasoline. They exist in some virtual world, not the real one. Where I live, I'm surrounded by boomers who eat and drive. These no-money-down folks don't really save in the classic definition; they invest. In other words, to them investing and saving are the same things. Half "save," half spend as much or more than they earn. The spenders are losers who will become whinier over time. The savers mostly do so via 401k, 403b, and IRA accounts full of stock and money market mutual funds, as opposed to their parents who saved via certificates of deposits, employer pension plans, and real estate. Boomers want a better deal. The boomers remember higher interest rates in the 80s and early 90s. Why do they minimize bond investments? They have a choice.
Here, a few words about certificates of deposit might prevent several emails. Baby boomers and their children would choose US treasury securities over CDs by a wide margin. Banks and credit unions have transformed from depositary institutions into transaction institutions. Certificates of deposit entail too much form filling and/or rules, not enough payback. Treasuries are more liquid and flexible. The treasury menu from the point of view of a retail buyer follows: open end mutual funds, ETFs, brokerage accounts, savings bonds, treasury direct account, all at the click of a mouse. A bank is for a checking account, a safe deposit box, an ATM card, and maybe a car loan. Who needs a bank for investing?
Barring a sudden catastrophe, which forces boomers to liquidate their tax advantaged accounts, they will buy US Treasuries, given an attractive deal. Two possibilities against this scenario are a financial system collapse and a sudden a currency devaluation. Financial system collapse is not so likely, considering government insured bank deposits, an activist Federal Reserve armed with money creating powers, and the plunge protection team floating the big money boys. Also, please don't confuse currency devaluation with ordinary inflation; the timescales and results are vastly different. Devaluations, such as the one in Argentina in 2002 that doubled and tripled prices virtually overnight, that many people mistakenly think can’t happen here in the US, cause a nation's economy to seize up like a heart attack. Inflation like the US has seen for 25 years is merely a chronic sickness. Although they don't think in terms of real interest rates, boomers have a feel for inflation. Moderately increasing inflation would only cause them to shorten maturities that they buy. For example, with the assumption that the whole yield curve meets the indistinct “high enough” point, 2 year notes would substitute for 10 year notes.
Let's do a first cut rough estimate. The demographic bulge of US baby boomers numbers approximately 80 million. Half with liquid investments is 40 million. Assume an average of ten grand per person, if the interest rate is high enough. 40 million times $10,000 is $400 billion. Plus buying from other generations and US institutions, such as pension funds, insurance pools, and university endowments, increase that sum by half to $600 billion. Everybody buying or selling everything instantly, all at once just doesn't happen, particularly with a market as large as that for bonds. As buyers on the margin, American buyers led by increasingly retirement conscious and conservative boomers would soak up Asian central bank selling, let alone new issuance, for quite a while. But not at 4.5%.
Millions of baby boomers, with help from older and younger people and institutions that serve them, will buy US treasury bonds if foreign agents don't. If the price is right. And as they age, the half that do save will save more than now. Just as the 1980s killed the ugly fashions, odious disco music, enervating stagflation, and the poor real interest rates of the 1970s, so too the end of the world will not happen if John Q., Jane, and Neo get better bond deals. Indeed, that will be a good thing. In the meantime, we'll all be stuck in a bond matrix with occasional nasty fights against economic agents.
Copyright ©2007 by Chuck DiFalco
